Correlation rather than contagion
February 28 2007 (Financial Times)

Why did so many world markets sell off on Tuesday? On the surface, there are similarities to the Asian crisis of 1997, which gave markets the word contagion financial and currency crises spread from one country with weak economic fundamentals to another, until European and US markets also suffered.

This time, however, several analysts suggested that the cause was slightly different. Rather than contagion starting in China, where markets fell 9 per cent on Tuesday, they suggested that there was a correlated fall that involved many different assets that appeared over-valued and, therefore, unattractive for investors who had become more nervous about economic risks.

David Bowers, managing director of Absolute Strategy Research in London, said that correlation between asset classes was increasing. He drew a comparison be-tween investment in China and the bubble in tech stocks in 1999 and 2000. China could grow at 10 per cent forever. But people forget that the consumers of their products are essentially cyclical. And they are, essentially, US consumers.

US demand has come in weaker than expected. Maybe the China story and the subprime story are linked, he added. The weakness in housing is going to cause real problems in the supply chain to the US consumer and that could be US small-caps, or it could be in Asia. The saying these days is that the only thing that goes up when the market goes down is correlation.

AntiSpin: Today speculation over yesterday's global market slide, which continued in Asian and European markets but not in the U.S., centered on the relationship between China's markets and the rest of the world. I speculated yesterday that Greenspan's unusual public speech Monday about a U.S. recession this yeara first for a standing or retired Chairman of the Fedwas intended to talk down (risk adjust) over-priced global markets by suggesting that a primary source of global demandthe U.S. consumermay take a breather. The catch-word today is "correlation."

The FT reporter in the piece above confuses the asset correlation with global stock market correlation.

Positive asset correlation is the unusual circumstance of asset classes which have historically had a negative correlation, such as commodities and stocks, moving up and down together in price. You'd be hard pressed to find one asset class among stocks, bonds, real estate, precious metals, junk bonds, or private equityto name a fewwhich have not move together in the same direction for the past few years. Recently real estate broke ranks, along with related securities, such as Mortgage Backed Securities (MBS), Collateralized Debt Obligations (CDO), and related credit derivatives (insurance against losses from default.)

Yesterday, for example, the stock markets fell around 4%. So did gold. Back when gold was a flight to safety asset, a major market correction sent at least some flight capital into gold. That may happen again, when the willingness of global central banks to inflate all currencies to avoid a global debt deflation is more widely understood. Only U.S. treasuries came out as the clear winner yesterday, the beneficiary of a rush to perceived safetyhelps explain why only U.S. stock markets among global markets did not continue to decline today. (Either that, or the markets were taking back yesterday's 200 point ten minute technical loss.)

In the context of Ka-Poom Theory, here at iTulip, we call the post 2004 period of positive asset correlation the All Assets Up phase of the post 2001 global central bank reflation "Poom." Expect an equally unusual All Assets Down "Ka" process to follow at some point, as global credit markets contract, starting with the canary in the coal mine, the sub-prime segment of the U.S. housing market.

The market correction yesterday demonstrated positive asset correlation reversing prices, and also global market correlation. However, rather than correlated to global liquidity as are asset prices, global stock markets are correlated to U.S. consumer demand. Global stock market values are a function of return on riskputting risk aside for nowreturn is a function of economic growth. Global markets reacted yesterday to the surprise Greenspan announcement that U.S. economic growththe primary source of demand for the economies hosting the various bourses that fellmay go into reverse later this year. No standing or retired Fed chairman has ever made such a assertion in public before.

There is another key lesson we can take away from yesterday's market events. The fat cats of the global marketsthe U.S., Europe, and Japanhave participated for 40 years in a global economic system which extracted surplus income from every other other country in the system, including China. Yesterday's global market correction was for the first time centered on China, rather than emanating from a small economy at the periphery of the system, as in the case of the Asian currency contagion episode of 1997/1998. Economic M.A.D. explains how the U.S. now relies for foreign investment, to fund trade and fiscal deficits, on a Chinese economy that runs on credit and corruption; China relies for demand for exports on a U.S. economy that runs on asset speculation, significantly financed by foreign investment. From now on, with each shuddering shift to a new global monetary system, this unstable dependency, in the context of a disintegrating, aging global monetary system, will become more apparent.